Risk Management Reports

September, 2003
Volume 30, No. 9
 
Risk Avarice or Aversion?

I have maintained for many years that one important goal of risk management is to seek and maintain a rational balance between excessive risk-taking and excessive risk aversion. “Betting the farm” is akin to plowing your entire savings into lottery tickets. You might win, bringing instant wealth, but the odds in favor of losing your investment are inordinately high. Similarly, eschewing risk at all costs will almost always lead to disappointment as your organization withers and dies from lack of innovation. Selfevident, you say, but how do today’s organizations measure up on their “risk balance?”

Three authors give contradictory opinions, the first two in a recent article in Harvard Business Review and the third in a book from England. Both cases are persuasive and worth reading.

The Nobel-laureate Daniel Kahnemann, from Princeton University, and Dan Lavallo, a senior lecturer at the University of New South Wales, argue in “Delusions of Success” that “in planning major initiatives, executives routinely exaggerate the benefits and discount the costs, setting themselves up for failure.” The authors suggest this is attributable to the latent optimism that resides in all of us. A new project proposal inevitably comes with enthusiastic sponsors who over-estimate its positive attributes. Similarly, these sponsors tend to “neglect the potential abilities and actions” of competitors. They assume that rivals will fail to respond or move too late. And finally, when an organization has limited funds for new projects, those selected for investment will be the ones carrying “the most over-optimistic forecasts.”

Kahnemann and Lovallo believe that “optimism generates much more enthusiasm than it does realism (not to mention pessimism).” Is this a new and recent phenomenon or has it always been so? I suggest this been a continuing characteristic of our human species. The authors then suggest five steps to correct the optimistic bias they say is found today in many organizations:

  1. Select a “reference class” of outside data or organizations with which to compare the proposed project, and rank your idea against them.

  2. Assess the distribution of outcomes of these projects/data, taking care to consider carefully the extremes.

  3. Make an intuitive prediction of your project’s position in the distribution.

  4. Assess the reliability of your prediction.

  5. Correct your intuitive estimate.

 Sounds very much like traditional risk management thinking, doesn’t it? Kahnemann and Lovallo conclude that most managers are “likely to underestimate the overall probability of unfavorable outcomes.”

The contrary opinion comes from Benjamin Hunt, a UK journalist. “Business is terrified of taking risk,” he writes. In The Timid Corporation, published by John Wiley & Sons Ltd. earlier this year, Hunt argues that today’s corporations are enveloped in a cloud of “irrational pessimism,” and that “risk aversion has become more of a permanent mindset and mode of operation, independent of the business cycle.” He sees risk aversion “institutionalized in business.” Part of the blame lies with risk management itself: “the problem with the enormous rise of risk management is that it entrenches a new intolerance of risk and uncertainty.” On the surface, Hunt is at odds with Kahnemann and Lovallo. 

The Timid Corporation is meticulously researched but, with a seven page bibliography full pages of books and articles. Unfortunately, most of them come from the insurance and finance arenas. Hunt did not tap any of the vast resource of public policy risk management documentation. It might not have changed his gloomy prognosis but it would have enriched it. 

Hunt begins his first section by castigating the “re-regulation of the corporation,” a process that entrenches caution through both external and self-regulation. He tackles briefly the problems of the risk management discipline and then suggests that managing for shareholder value creates a new form of financial risk aversion. His second section suggests that industry has adopted a “defensive mode” and that it is obsessed with the customer. Through an emphasis on brands and customer loyalty, it has “dumbed down innovation.” All this leads to a “fear of growth.” Finally, Hunt describes the current “crisis of self-belief” and sets forth suggestions for breaking the current paralysis.

 

I can’t accept his entire thesis but pieces ring true. For example, Hunt writes: “Rather than take a lead in upholding strong principles and shaping change, corporations attempt to ‘listen to society’ and ‘listen to the customer’. But the world around them—including the business world and broader society—has also become more risk-averse at the same time, and newly demands caution and restraint in behaviour.” This is a valid point: corporations are a part of the culture and it is undeniably more cautious today than a decade ago. After the shocks of the breaking bubble and the advent of global terrorism, a fresh emphasis on regulation is understandable. But Hunt says that the “holy trinity of accountability, responsibility and transparency” has moved too far. The precautionary principle in public affairs has been adopted by business: “do not experiment unless the outcome is safe and poses no risks.” He equally criticizes self-regulation, with the rise of interest in ethics and corporate governance. I agree with him when he writes: “just repeating the term corporate governance more than a few times in one day can make lips seize up with dryness!”

Then Hunt argues that listening to society can be irrational, citing the example of the Brent Spar fiasco. True, but that case and others similar to it do not mean that it is improper to engage other stakeholders in serious discussions about risk. I believe that it is worthwhile, over time, to reach out to the public and especially to NGOs, even when they spread nonsense. 

The author’s dissection of risk management is both savage and incomplete. Yes, too many insurance and financial risk managers are paranoid about uncertainty and come on as the resident corporate naysayers. True, managers can be easily frustrated when “highly tedious, door-stopper-like risk management manuals land with a thump on their desk(s), and they are asked to wade through them before making a decision.” But most of today’s risk management practitioners can entwine logical and reasonable risk analyses within their organizations without recourse to monumental tomes. Hunt’s history of risk management is flawed as it is almost entirely related to its development within insurance. His notes indicate that he interviewed 14 “risk managers,” but, from the tone of this chapter, most of them must have been insurance risk managers, leaving our credit, market, public policy and other operational risk practitioners. He cites no names or titles, so I cannot be sure. Hunt also perpetuates the discarded and thoroughly discredited distinction between “passive” and “speculative” risks, a construction of the insurance industry to avoid taking on risk with which it was unfamiliar. Most observers today accept that risk involves both upside and downside potentials and that trying to separate them into distinct packages is a disservice to the idea of treating risk holistically. 

Hunt’s attack on the “new obsession with the customer” goes too far. When Ralph Nader wrote Unsafe at Any Speed in the 1960s, the prevailing legal dictum was caveat emptor – let the buyer beware. Nader argued successfully that much more was required of the selling corporation and the consumer movement began. Today, largely as a result of Nader’s continuing work, the current dictum is caveat vendor – let the seller beware. 

Perhaps the pendulum has swung too far, especially with litigation in the US, but it has redressed a prior imbalance. Hunt’s argument that today’s corporation is fixated on customer loyalty and brand protection may be true but I’m not ready to accept the conclusion of his syllogism that this leads to the stagnation of innovation and a fear of growth. I do agree with his identification of a major current irony: “just at a time when managers and corporations see the world as more risky and unpredictable and are more defensive, a range of commentators view corporations as wanting aggressively to ‘take over’ the world.” 

Hunt argues that a social climate of risk aversion affects corporations but does this instill excessive caution in all of them? I admit to being more of an optimist: it’s only a temporary mood. I do agree with his two suggestions for change: take a more critical attitude toward regulation and self-regulation, and raise expectations of technological progress. The latter will occur and will shift us out of our malaise! Finally, Hunt is right when he writes that “in this world, it is worth bearing in mind that a society that does not try to shape its future ends up by being dictated to by its anxieties. 

So we have two views of our current situation. One says that organizations are too risk avaricious, the other that we are too risk averse. Take your pick!

The ideal is to draw a clear distinction between those functions and positions that involve or support decision-making and those that promote or guide action. The former should be imbued with a realistic outlook, while the latter will often benefit from a sense of optimism.

Dan Lovallo and Daniel Kahnemann, “Delusions of Success,” Harvard Business Review, July 2003

Copyright 2003, by H. Felix Kloman and Seawrack Press, Inc.

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